Paul Krugman says that economics had the answer to how to respond to the crisis. It’s just that policy failed to follow the prescription. The textbook said that private demand was deficient, and that what we needed was more public spending to fill the gap.

I don’t think this tells even nearly all the story. The ‘textbook’ just isn’t as unambiguous as PK would have you think. The reasonable and non-partisan economist could take widely differing views on what should be done. And many of these are built on models which are silent about the mechanisms that gave rise to the crisis in the first place. Economics hasn’t properly resolved what caused the crisis nor how best to respond to it. All the big questions are still up for grabs. Into this gap plunged policymakers who had to do something about it without a clear prescription, and were given the opportunity to fashion a response that pandered to their own political instincts (UK Tory desire for a small state). In the case of the US, the up-for-grabness of the economics leant strength to the Tea Party Republicans pushing the argument that failed state policy could only be cured by less state, not more.

The old (but, historically, still ‘post’) Keynesian, IS/LM account of deficient demand, pretty much resembles the more modern account embedded in the rational expectations, sticky price models, dubbed ‘new’ Keynesian. But using these models to prescribe drastic fiscal expansions that greatly exceeded what we saw is problematic. In the UK, inflation exceeded target substantially. In the US, it has not fallen all that much below it. Modifications of the New Keynesian model that have a financial sector explain the recession as a dramatic constriction in credit supply that both strangles output, and creates inflationary pressure (offsetting the depressing effect on inflation coming from the fall in demand).

Following this line of argument, conventional demand-side fiscal policy was roughly on track. You might argue that we ought to have had very great deviations of above target inflation, and much looser conventional fiscal policy. But to do this you would have to ditch what those models say about the costs of inflation. They contain the view that inflation fluctuations are an order of magnitude more costly than fluctuations in real activity. So much the worse for them, you might say. And policy makers frequently have said this. But, with the models thus binned, you are in the dark about what should be done. And there’s no way you can then argue that economics gives a clear answer, since you have discarded the one bottom-to-top [microfounded] answer it does give. Granted, not everyone goes in for bottom-to-topness. But that just reinforces my point that there is no sound economic answer.

Things are obviously worse than this, because the models that Paul Krugman is using to reason his way to arguing for a drastic further fiscal stimulus don’t contain financial sectors. And the ones that get bolted onto the New Keynesian models to argue that policy was about right contain financial sectors that aren’t subject to systemic runs; don’t malfunction therefore in the way that the real one did.

One of the themes of the early post crisis debate was the controversy between those like the Tory-led Coalition in the UK who warned about the possibility of a run on UK sovereign bonds, and those like PK who dismissed these concerns as opportunistic invoking of the ‘bond market fairy’.

PK would have history judge that he made the right call on this. Certainly there were no runs on UK or US bonds. But economics itself could not have given such an unambiguous a steer as PK claims. The literature on optimal fiscal policy is riddled with ambiguity. How to view what government does: wasteful, substituting, complementing private expenditure? How to model the possibility of runs, and on what they might depend? Whether to accept the possibility of the fiscal theory of the price level. [And whether this should be viewed as a difficulty or, as Sims sometimes suggested, an opportunity]. How to account for why people hold money. [Without a good account of that, we can’t confidently say how they will price nominal bonds]. Whether the government can be viewed as being able to commit; if not, whether it can acquire a reputation for good behaviour. [If they can commit, then borrow now pay later strategies will work better]. Whether prices are sticky or not. [This affects how much work fiscal policy should do to stabilise]. How to assess the tensions in the intergenerational conflicts over fiscal policy. [Another take on the commitment problem]. How to produce normative guidelines for good fiscal policy that weighs concerns of competing generations. The imponderable questions regarding how policy should deal with uncertainty, applied to the task of designing fiscal policy. [How to weigh the unknown risks of a sovereign run, versus a deflationary spiral, for example].

I don’t know what economics PK has read. But the miserably small quantity of serious reading I have managed on the above issues leaves me thinking that economics does not offer the clear advice PK claims. PK seems to be backing away from all these intractable debates about the detail, and saying that we can ignore it. Big picture, demand was weak, public demand had to be stronger. Politicians did not get this message clearly enough, and were able to ignore it. End of story. Well, maybe. Maybe not. Perhaps only great minds can see the wood for all these unfinished modelling trees. But to me it looks like a mess that many decades of future research may not sort out.

I think a plausible account of public policy failure is that our economics profession had not yet come up with clear answers. And in the absence of this politicians were free (or perhaps had no choice but) to be guided by their baser political imperatives.

17 Responses to Did economics fail?

The surprisingly widespread fear that there could be escalating bond run on UK and US government debt is a seriously mistaken. It is based on the misunderstanding that countries that create their own currencies can actually be forced to default on debts in the same currency. How can one run out of currency that you create? The delegation within those countries of money creating powers to central banks does make this technically possible, but it is hardly plausible, and has never happened. It would require the central bank to act in a way that was extremely damaging to the country and for the elected government and legislature to allow the central bank to behave in this way.

Run used informally. Ie one might get hyperinflation on the expectation that the central bank prints to help finance the government. But it’s perfectly plausible that the government chooses to default rather than use seigniorage to finance. For example, Argentina. Seigniorage is an extremely wasteful and costly form of finance, as the Argentinians no doubt decided.

Argentina had debt in USD or pegged to USD so does not count. The only example I am aware of where a government defaulted on debts in its own currency is Russia, where it was trying to maintain a currency peg. Obviously of you are defending an exchange rate peg you may decide to default but you cannot be forced to default. Defaulting on debts is far more damaging in both the short and long run than allowing the central bank to use it money printing powers to purchase government debt. The ECB demonstrated this very clearly when all it took was for Draghi to say the ECB was prepare to resort to printing money to prevent a bond run. That cost precisely nothing.
The notion that central bank money printing causes hyperinflation is wrong both in theory and in reality. Experience over the past 5 years has made that crystal clear. obviously there is a risk if it is excessive. But when it is used to cope with a financial crisis and fiscal deficits arising from a major recession it is obviously not going induce hyperinflation. one has to have a bizarre and dated view of the monetary system to think this.

Yes it does. Both came off their pegs. They didn’t default so that they could try to stick to them. They defaulted because it would have been socially disastrous, and maybe not even possible to raise enough money through seigniorage, at least not quickly enough.

If after all these years the economics profession has no advice to offer about public policy matters, what good is it? Why not take up some other and useful line of work.

PK and other Keynesians did predict that large budget deficits and very rapid growth in the supply of money would not lead to soaring interest rates and soaring inflation. More than five years on this has proven to be correct.

How long do you think Friedman had in mind for the effects to take effect? If one stretches it out toward infinity then there is no useful information there either.

So, because there are multiple economic models, the question of which one predicted most correctly is irrelevant? This because the existence of multiple models means that economics has multiple answers, and therefore no answers? Not every economist was correct, so economics has nothing to offer?

That seems like a working definition of sophistry.

You claim to have read multiple economics articles that offer differing advice. Congratulations, you seem to know how to read. Unfortunately for you, you do not seem to know how to compare the differing advice to actual events in the real world to discern which advice was best. By the way, it’s “bond vigilantes” and “confidence fairy”, not “bond market fairy”, so your reading might not be so good, either.

No offense, but when you find yourself writing things like this …
“the miserably small quantity of serious reading I have managed on the above issues leaves me thinking that economics does not offer the clear advice PK claims.” … about someone with a Nobel Prize in the subject and regarding something they successfully predicted 5 years in, it might be time to shut up and listen.

The debt that caused Argentine a problem was in USD or pegged to the USD (convertible at 1:1 ratio), which is the same thing. That is entirely different from the UK/USA debt position. If a country owes money in its own currency and has a floating exchange rate it is a trivial matter to pay it back. Just a matter of changing numbers on the spreadsheet the central bank maintains of reserve balances. How can this be difficult, costly, wasteful or slow? The only short term risk is depreciation of the currency by investors worried about inflation, but unlike the dynamic of foreign currency debt default, which is unstable, this depreciation stabilises automatically and has no effect on the debt burden.

I am somewhat boggled at this time by the notion that there could be a non-partisan economist, when a brief review of economic writing indicates that there are several competing schools, with the Chicago/Freshwater school having an overwhelming policy voice, the saltwater/New Keynesian as the loyal opposition, and a variety of smaller players of little utility to policy makers (MMT, Austrian, Marxist).
How likely is it that a member of one school could be reasonably convinced to abandon their school for another through argumentation?

“How likely is it that a member of one school could be reasonably convinced to abandon their school for another through argumentation?”

Very very unlikely.
As we have seen during the last few years, no sooner had we realized M. Friedman, R. Lucas, E. Prescott and T. Sargent are nonsensical than we saw people jump out to say they are wrong indeed and so is everybody; we don’t know how to deal with the Great recession…….

May I suggest a reading of “Merchants of Doubt.” Uncertainty of conclusions will always be present in all science-and that includes economics. The job of the educated economist is to have the skill to ascertain which models most closely reflect real world behavior. After 5 years of observations in the US it is clear that PK was indeed correct. You however, seem to believe that the fact that “alternative models” exist makes the one generating the correct predictions subject to question. How much proof is necessary for you? Like the climate change deniers, you apparently require all economists to adopt one single model before you believe it to be worthy of policy makers’ attention. Even 97% would not be enough to satisfy your criteria.

It’s simply not true that PK was ‘right’ or proved so by the data. Suppose we are Bayesian. Start out with equal probabilities on all the models we don’t think are not plain stupid. And let the data produce the posterior probabilities on the models. The data won’t ‘prove’ that PK and SWL’s explanation is ‘right’ at all. The pre and post crisis data will leave many models on the table still. Including one example I gave, which is that the demand deficit was matched by the monetary and fiscal stimulus we saw, hence roughly constant inflation; and that the explanation for weak activity is the constriction in credit supply from the malfunctioning banks. In this example, a perfectly good model explains the data but gives a contrary prescription to PK and SWL. This is not at all like climate change modelling. In that field there is overwhelming evidence from multiple different sources that human activity has induced climate change. There is nothing like the consensus of results in macro, nor the grounding of the individual models in well-understood fundamentals (which in climate change = physics).

Another ‘experiment’ performed by the coalition government was to impose fiscal tightening when a recovery was already underway. Monetary policy was unchanged. Growth slowed down dramatically, almost resulting in another recession. The tightening was stopped (in the sense that despite the deficit remaining high no further cuts were introduced) and the recovery kicked in again.Seems like pretty strong evidence in favour of Krugman’s model.

That’s just evidence in favour of any model that displays a non zero fiscal multiplier, which would include any model with sticky prices, and or credit constraints. including the particular one that i describe in the post which was used, for rhetorical purposes, to support the actual fiscal policies put in place, not the more stimulative ones argued for by krugman. the ‘experiment’ afforded by the whole time series of output, deficits and inflation (plus all the other variables you would use to estimate the model) is not enough to validate the ‘more stimulus was needed’ argument. it would be enough to validate the argument that fiscal policy should be counter-cyclical. but remember, fiscal policy WAS countercyclical. just not enough for pk or swl.